Investment Decisions



Investment projects are a big and an important part of Romania's economy. Through this thesis we can find out more about the profitability of an investment, more specifically, in the case study I chose a project from the oilfield area, where I'm trying to find out the impact of having the biggest mud plant from the country, built after German standards.
Investment notion defines a complex and very controversial financial category. At a first look, investment appears just as a growth in the company's initially heritage: industrial and civil construction, acquisition, assembly and installation of industrial equipment, purchase of machinery, etc.. At a second look and a deeper analysis, investment is capital allocation with a profitable purpose that will increase the amount of capital used.
Investment decisions typically involve the commitment of large sums of money, and they will affect the business over a number of years. Furthermore, the funds to purchase a capital item must be paid out immediately, whereas the income or benefits accrue over time. (Michael Boehlje and Cole Ehmke, Capital Investment Analysis and Project Assessment)
It is mandatory for management to become very circumspect about allocating limited resources among competing opportunities. The critical decision of allocating resources for a project is known as capital budgeting. The ability to make such a critical capital allocation decision requires a proper estimate of the worth of each opportunity concerning the projects which is a function of size, timing and predictability of future cash flows.
Most academicians state that effective cost allocation for an investment project can best be achieved with a sophisticated capital investment process. They assume that a sophisticated process increases the probability of making relevant investments by ensuring that corporate strategy will be followed, that all investment opportunities will be considered appropriately and consistently, and that the counterproductive political aspect of informal decision making will be minimized.
Because investment decisions rank among the most critical types of managerial decisions made in a company and can have major long-term implications, both positive and negative, for the success of a company, managers must understand how financial investment decisions are made if they are to participate in improving corporate performance.
Ultimate part of the research on financial investment analysis has been conducted by financial scholars who have developed project evaluation techniques. Though, there is a management literature that takes a process approach to the subject and places financial evaluation in the context of a complex organizational decision process.
The rest of this paper is organized as follows. In the first section I present in detail the project evaluation process and the main investment criteria, from both financial and non-financial analysis. In section two, I present a detailed analysis of the data, through the case study and discuss othe results both on their own and in the context of existing literature. I placed most of the tables, which summarise the financial analysis calculations, at the end of the paper (Appendix) due to their large extension. Finally, in the last section I present my conclusions and advises for this investment project.

2. Project Evaluation ' Investment Criteria

Effective investment decision making is essential to corporate survival and long-term success. These decisions help to mould company's future opportunities and develop competitive advantage by influencing, among other things, its technology, its processes, its working practices and its profitability.
Completing a thorough investment analysis may seem complicated and difficult. But the reward of a soundly based decision will be worth the effort invested to learn the process and collect the necessary information. (Michael Boehlje and Cole Ehmke, Capital Investment Analysis and Project Assessment)

There are several important features for an investment decision making to be effective (Boquist et al. (1998), Adams et al. (2004), apud '.):
' It is dynamic, not static. It explicitly recognizes that the quality of information can be improved over time. Thus capital budgeting should be a sequential, multiple decision process that integrates the information needed to obtain cash flow estimates into the financial analysis of the cash flows.
' It is linked to the strategy implementation in relation to the company's multiple stakeholders. Therefore, project proposals should be supported by relevant non-financial data and forecasts.
' It recognizes the options inherent in value-enhancing capital budgeting.
' It takes a cross-functional approach. The quality of estimates of expected cash flows and the
uncertainty in cash flows are critical. Since the underlying information for these estimates comes from many functions within the company, those providing information must see themselves as strategic partners in the process.
The investment decision rules may be referred to as capital budgeting techniques, or investment criteria. A sound appraisal technique should be used to measure the economic worth of an investment project. The essential property of a sound technique is that is should maximize the shareholders wealth. The following other characteristics should also be possessed by a sound investment evaluation criterion:
' It should consider all cash flows to determine the true profitability of then project.
' It should provide for an objective and unambiguous way of separate good projects from bad projects.
' It should help ranking of projects according to their true profitability.
' It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.
' It should help to choose among mutually exclusive projects that project which maximizes the shareholders wealth.
' It should be a criterion which is applicable to any conceivable investment project independent of others.
The importance of investment decisions has lately even increased. There is a short of available funds in the current world economy due to the financial crisis, and thus all the investments and capital allocations must be directed to profitable projects. In times of uncertainty, companies also seek ways to expand their operations to new areas of business, whether the expansion is geographical or operational. In these types of situations, strategic and long-term aspects become more important than short-term profit. On the other hand, the pressure to comply with the financial targets set to the management is playing key role in some organisations' strategic investment decisions (SID's).
Investment decisions, and also strategic investment decisions, have been studied in the light of utilized capital budgeting techniques quite thoroughly in the current literature (e.g. Alkaraan and Northcott, 2006; Arnold and Hatzapoulos, 2000; Farragher et al., 1999; Graham
and Harvey, 2001; Pike, 1996; Sandahl and Sj??gren, 2003; Liljeblom and Vaihekoski, 2004).
These studies have concentrated on the techniques that are used and not that much on how they are used and what contextual setting affect to the use of appropriate techniques. Research evidence also indicates that organisations weight strategic and financial aspects quite differently (e.g. Carr and Tomkins, 1996, 1998). Also differences between different countries (compare e.g. Graham and Harvey, 2001; Sandahl and Sj??gren, 2003; Brounen, De Jong & Koedijk, 2004) and small versus large corporations (Graham and Harvey, 2001; Pike, 1996) have been observed. The caveat, however, has been that no studies have sought to create systematic approach to explain the above mentioned differences in applied capital budgeting techniques of organizations.
2.1 Financial analysis

Projects of investment character can be in term of quantitative outputs characterized by three basic factors, mainly by cash flows, or by the difference between receipts and expenditures resulting from the investment, by the real service life and by the risk, that is run by implementation of the investment and for which the enterprise should require an adequate return. There are many methods or criterions for evaluating capital projects that approach to these basic factors in different ways.
Criterions of evaluating projects from a financial analysis point of view can be divided into two groups ' static and dynamic criterions. Static criterions consider mainly cash flows. They consider time in constraint mode and in principle they do not work with risk. They include e.g. total investment income, net total investment income, annual average returnability, average payback period, payback period.
Dynamic criterions take into account all three factors which mean cash flows, service life and undergone risk as well. They involve e.g. Net Present Value (NPV), Internal rate of return (IRR), Profitability index (PI), Discounted Payback period (PP).
During the evaluation of investments, other instruments are being used, mainly in connection with integration of the risk and uncertainty into this process of evaluation. They include above all sensitivity analysis, scenarios and simulation techniques. Evaluation of flexible investment projects is enabled by real options.
Choice of a criteria for evaluating investments from a financial point of view reflects more aspects, mainly preferences of the decision-maker (impact on relative or absolute profitability, stress on short Payback Period, existence of the budget constraint).
Although the financial area covers many ways to evaluate a project, most of the companies consider the most important net present value, after it the internal rate of return (IRR) as beeing a relevant decision criteria as well. They also prefer to use scenario analysis, payback period and benefit/cost ratio. The least relevant financial techniques are real options, accounting rate of return, break-even point and simulation risk (Graham and Harvey, 2001 study).

2.2 Is financial analysis enough?

Recent literature has been emphasising the need to take both financial and nonfinancial aspects into consideration when considering capital budgeting decisions. This is to be done since the early stages of project appraisal, and not only when risks become reality. We wanted to know to what extent portuguese companies are aware of the importance of non financial aspects at their project appraisal processes, and, in their practices, what exactly they are doing and considering as more or less important.
There are several traditional methods used by analysts for evaluating a project's viability. These include the net present value, internal rate of return, payback method and others. However, none of these investment assessment tools for capital budgeting takes into consideration the uncertainty of variables that may occur in the future. While, the traditional methods of analyzing projects are widely accepted, they neglect management's ability and flexibility to respond to uncertainties that are likely to affect their projects. The traditional methods typically assume a single line of development for a project and simply incorporate the probability of failure into the overall expected value for the project. The probability of failure is carried as a discount rate that in itself is a very hard value to assign.
The decision-making process for investments is complex and goes beyond the financial aspects. Skitmore et al. (1989) point out that 'any knowledge that can help the decisionmakers(...) to recognize and minimize the uncertainty and risk is expected to have somepotential value'. Many of the project's goals tend to be qualitative and not easily measurable, apart from being long term goals and not immediately verifiable. Andreou et al. (1989) note that a project generates externalities, in terms of costs and benefits that are not taken into account in financial forecasts. The financial techniques must be used only as a guide, or a baseline, and other factors that may influence the uncertainty analysis must be considered.
The financial evaluation is only a part of the decisionmaking process and additional information is needed. Therefore, even if the financial conditions are extremely favorable, neglecting some of the qualitative aspects may cause serious problems. The capital budgeting process must enclose a wide spectrum of analysis dimensions, whether financial or not, as a way to fully study all the aspects that may influence its viability.
2.3 Non-financial analysis

Myers (1984, a, p. 131) refers that 'the non-financial approach taken in many strategic analyses may be an attempt to overcome the short horizons and arbitrariness of financial analysis as it is often misapplied'. Non-financial factors can influence the investment decision in that it can influence the viability and success, as well as affect the financial analysis through the cash flows and the discount rate of the project. The problem is that there are many non-financial aspects that are not easily translated into monetary terms, because some factors are difficult to estimate and can produce evaluation errors easily. The difficulty in evaluating these aspects is related to their intangible nature and measurement problems, which make this analysis highly subjective.
Mohanty et al (2005, p. 5199) refer that qualitative attributes are 'often accompanied by certain ambiguities and vagueness because of the dissimilar perceptions of organizational goals among pluralistic stakeholders, bureaucracy and the functional specialization of organizational members'. This might be one of the reasons why the practice of firms still has a long way to go.
Mohamed and McCowan (2001, p. 232) consider that the 'lack of know-how in measuring strategic and intangible (qualitative) costs and benefits led current models to ignore their contribution to the overall economic analysis'. In this way, Lopes and Flavell (1998) recognize that a 'major reason why non-financial and non-technical aspects are not considered more fully during project appraisal is probably the lack of an analytic framework that would highlight the importance of those aspects and would provide guidelines on how to incorporate them into the appraisal'.
Therefore factors like: commercial, political, social, environmental, organizational, human resources and project manager, should also be taken into consideration when you evaluate a project.
' The human resource factor:
Large companies place more importance, relatively to small companies, on interpersonal relationships, the ability to work as a team, joining people with complementary skills, problem-solving ability, the level of unionized workers, attribution of autonomy, authority and responsibility, incentives to team spirit and collective decision-making. In expansion projects, compared to other types, less importance is attributed to the ability to evaluate risks, joining people with complementary skills, trust between team members, incentives to team spirit and collective decision-making. In long term projects greater importance is attributed to the ability to evaluate risks, the ability to work for common goals and trust between team members, and less importance is attributed to external recruiting. Note also that internal recruiting tends to be more important in companies where the CEO's tenure is short, and when the project manager is also on the board/administration. We also see that when CEO's tenure is short, when the project manager is young, and when the decision is made by someone who is not on the administration, the perspectives of future Large companies place more importance, relatively to small companies, on interpersonal relationships, the ability to work as a team, joining people with complementary skills, problem-solving ability, the level of unionized workers, attribution of autonomy, authority and responsibility, incentives to team spirit and collective decision-making. In expansion projects, compared to other types, less importance is attributed to the ability to evaluate risks, joining people with complementary skills, trust between team members, incentives to team spirit and collective decision-making. In long term projects greater importance is attributed to the ability to evaluate risks, the ability to work for common goals and trust between team members, and less importance is attributed to external recruiting.

' Project Manager Analysis

The choice of a Project Manager (PM) being the leader of the project needs special attention. The role of the project manager is mainly related with understanding the business's environment and delegating and attributing responsibilities. As for the attributes identified as needed: management skill, decision-making skill and leadership skill stand out as the most important ' as in Shenhar et al. (1997), Turner and Muller (2003, 2005), Pozner (1987), Pettersen (1991) and Thoms and Pinto (1999).
On the other hand, in short term projects, the appropriate exercise of authority and the manager's creativity are more important than in longer term projects. In small projects the project manager's success within the organisation, ambition and energy are more important and the management skill is less important than in larger projects. Lastly, in those projects viewed as least successful manager's technical and motivational skills are more important than in more successful projects.
' Economic Uncertainty
Market variables such as the price of oil and gas, interest rate, and currency exchange rate are economic uncertainties that greatly affect the viability of a project. Another important factor is that the state of the targeted market economy that is where the commodities are intended to be sold is always an uncertain factor. An important question to be asked is whether consumers have the purchasing power to be able to buy the commodity. These economic factors are very volatile and correlate with the general movement of the economy. Uncertainty can be favorable when the price of oil and gas increases and the corresponding increase in purchasing power generates higher cash inflow.
' Political Uncertainty
Investors deciding to undertake a foreign investment need to consider political uncertainty and the likelihood of affecting their business. Firms encounter political uncertainty and complexity especially in the developing countries. These uncertainties and complexities are risks that range across economic, financial, legal and social conditions of the foreign country. In general risk from political uncertainty can be grouped onto two categories. First, there are risks that may not be directly caused by the government such as war, uprising of certain group, or other forms of violence. Second, there are risks that are caused through government policies, for example export and import restrictions, tariffs and taxes, price control, expropriation, devaluation of currency and other foreign exchange control.
Political risks stem from government policies which are exhibited through the national economy and social structures within the country. The host government tends to create risk for the affecting firm that can be manifested through its policies, laws, regulations and administrative pronouncements. They impose implicit transfer risk to firms in their country in many ways. It is sometimes evident when the government restricts the firm from sending remittance of earning or repatriation of profits to the parent firm. Another political risk that can affect foreign firms is operational risk. It is seen when government require the majority of employees to be hired for the operation from the country (or local area), but there may not be enough skilled workers as needed by the firm. Government policies at times pose serious problems to the firm when it is made to go through difficult work permit procedures for employing competent worker who do not come from the operating country.
The worst among the numerous risks is expropriation by government, in which government takes control of the firm by force and pays little compensation or nothing at all to the original owners of the firm. The act is usually exhibited by military takeovers in destabilized countries. It is an unacceptable behavior but may be encountered. Governments can sometimes pass laws to prevent proven oil and gas reserves and resources from being explored and produced due to environmental threats to the country, even when a firm has already acquired a lease for its operations. For example, the U.S Congress has enacted moratoriums on drilling and exploration in areas along the coasts of some states. These policies are intended to protect coastlines from even unintentional oil spills, although the Mineral Management Service estimates that there is an approximate 76 billion barrels of oil in the undiscovered fields offshore in the U.S. outer continental shelf (Jarmon & Anderson, 2007). However, government actions can also be affirmative and can have a positive impact on a project. The positive steps a government takes to aid companies can be seen in term of tax exemptions for some number of years, or tax reductions which decrease the cash out flows of the firm which may result a corresponding increase in profit.
3. Case Study: M-I SWACO Romania

3.1 Company presentation

With over 13,000 employees in more than 75 countries around the world, M-I SWACO is a vital part of the world's hydrocarbon exploration and production industry. The company is the leading supplier of drilling fluid systems engineered to improve drilling performance by anticipating fluids-related problems, fluid systems and specialty tools designed to optimize wellbore productivity, production technology solutions to maximize production rates, and environmental solutions that safely manage waste volumes generated in both drilling and production operations.
In August 2010, M-I SWACO became part of Schlumberger through its merger with Smith International. The primary driver behind this merger is drilling optimization. In order to sustain and increase world oil and gas production, higher levels of drilling will be necessary in increasingly challenging and complex environments. This means wells with longer and more complex profiles. Understanding the technical challenges and mitigating the consequent risk in advance of a drilling program can mean major cost savings and well performance improvement for our customers. M-I SWACO will play a critical part in meeting these challenges.
From its earliest roots, M-I SWACO recognized that it best served its clients, not by delivering drilling fluid products to the client's location, but by anticipating and planning for how those products would behave in the downhole environment, both to optimize drilling performance and to minimize the risk associated with fluids-related problems.

Source: Essay UK - http://ntechno.pro/free-essays/finance/investment-decisions.php


Not what you're looking for?

Search:


About this resource

This Finance essay was submitted to us by a student in order to help you with your studies.


Rating:

Rating  
No ratings yet!

  • Order a custom essay
  • Download this page
  • Print this page
  • Search again

Word count:

This page has approximately words.


Share:


Cite:

If you use part of this page in your own work, you need to provide a citation, as follows:

Essay UK, Investment Decisions. Available from: <http://ntechno.pro/free-essays/finance/investment-decisions.php> [20-10-17].


More information:

If you are the original author of this content and no longer wish to have it published on our website then please click on the link below to request removal:


Essay and dissertation help

badges